Capco partners Stuart Feffer and Christopher Kundro say that issues related to valuation of hedge fund portfolios will likely become the next major 'black eye' for the industry.
Valuation issues are already a factor in many headline-grabbing hedge fund blow-ups, and continue to be in the news. Recent evidence includes coverage of the SEC's staff report on "Implications of the growth of hedge funds," the
high-profile departure of a top fund manager at hedge fund Clinton Group, and the recent market-timing scandals in the mutual fund world.
Feffer and Kundro made the prediction during a LJH/Capco teleconference on hedge funds. They said: "Unless certain practices become more widespread, the industry faces a potential crisis of confidence with institutional and high net worth investors."
A recent study by Capco on "Understanding and mitigating operational risk in hedge fund investments" found that valuation issues were a primary or contributing factor in approximately 35% of hedge fund failures.
Capco suggests that investors and fund managers insist that hedge funds follow three key principles in their valuation processes to ensure proper pricing:
- Insist on strict "independence and separation of duties" in the valuation process. Long a fundamental principle of control in financial institutions, it is still unevenly applied in the hedge fund world. In short, this means that portfolio managers and traders should not be principally responsible for valuing their own portfolios (which is often the case currently). Instead this should be performed or checked by someone who does not report to the portfolio manager and is not compensated based on the performance of the specific fund.
- Ensure consistency of application of sources, methods, rules, models and process in valuations. When these are applied situationally, it is often a red flag for pricing problems.
- Increase the level of management supervision and oversight of the valuation process. There should be documented policies and procedures at the fund, and a way of making sure that these policies and procedures are followed, usually through internal audit and testing. There should be evidence of ongoing management review and actions taken when inevitable pricing discrepancies are found.
The call also discussed the common reasons for valuation problems, which include the inherent difficulties in valuing certain types of securities, as well as pricing mistakes, procedural problems, infrastructure issues, misrepresentation
Background Note: Capco is a global financial services and technology solutions provider. It assists clients in improving financial and operational performance, risk profile, and return on investments. It combines functional expertise in program and change management, business process innovation and technology deployment with extensive experience to help clients realize their strategies and goals. Its service offerings include enterprise transformation, systems integration, and risk management. Its technology solutions include both proprietary and third party software and address industry needs around connectivity, market infrastructure, and reference data.
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